Professional Documents
Culture Documents
By
William C. Wheaton
Raymond G.Torto
Petros Sivitanides
Jon Southard
CB Richard Ellis/TortoWheaton Research
June 1999
possible to insure hedge or plan for the predicted variability. A much greater
source of true return risk is the uncertainty that the forecast will not be correct.
Vector autoregressive models relate a system of variables to their own lagged values,
but not to current values.
1300
1200
1100
-2 S D
-1 S D
B ase Case
+1 S D
+2 S D
1000
900
800
700
1988
1993
1998
2003
2008
Year
30
25
-2 S D
- 1S D
B ase Case
+1 S D
20
+2 S D
15
10
1988
1993
1998
2003
2008
Ye ar
Completions (SFx100)
14,000
12,000
10,000
-2S D
- 1S D
B ase Case
+1S D
+2 S D
8,000
6,000
4,000
2,000
0
1988
1993
1998
Year
2003
2008
While the confidence intervals of the economic forecast are symmetric around their
expected values, the property market reactions need not be. The ability to generate
almost any level of new construction tends to limit rental values on the upside, while the
durability of built assets makes rent more volatile on the downside.
1100
1000
900
-2 S D
-1 S D
B ase Case
+1 S D
+2 S D
800
700
600
500
1988
1993
1998
2003
2008
Year
35
30
25
-2 S D
- 1S D
B ase Case
20
+1 S D
+2 S D
15
10
1988
1993
1998
2003
2008
Year
Completions (SFx1000)
14,000
12,000
10,000
-2S D
- 1S D
B ase Case
8,000
6,000
+1S D
+2 S D
4,000
2,000
0
1988
1993
1998
Year
2003
2008
Dollars ($)
1,000,000
800,000
-2 S D
-1 S D
600,000
T W B as e
+1 S D
400,000
+2 S D
200,000
0
-200,000
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Ye ar
Do llars ($)
1,000,000
-2 S D
800,000
-1S D
600,000
T W B ase
+1S D
400,000
+2 S D
200,000
0
-200,000
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
Y e ar
In LA this value is 8.15%, while in Washington it is 8.90%. This cap rate is applied to
the base year NOI numbers to calculate an estimated transaction price for
the prototypical building asset. The income forecast is then run for a long term
period (55 years) effectively assuming a perpetual hold. Then, calculate the IRR
that equates this property value with the perpetual net income forecast.
If this process is repeated for each economic scenario, then the
probability distribution of IRRs can be obtained. In Los Angeles, this approach
yields the five IRR estimates shown in the first column of Table 1 below. Assuming
a normal distribution of the scenarios, we can calculate the expected value and
standard deviation of these income returns in Los Angeles (and then
3
Washington). In the table, Washington not only has a lower expected IRR, but
also higher variance as well. Since individual real estate assets, or even specific
geographic portfolios of these assets are not traded in any current public
market, there is little reason to expect that they will follow CAPM rules.
Earlier, we observed that the Washington D.C. economy is less risky than
that of Los Angeles. Despite this lower economic risk, the real estate investment
risk in Washington D.C., as judged by the standard deviation in IRR, is somewhat
greater than in Los Angeles. The reason, of course, is the greater volatility of
supply and that a building boom is well underway in Washington. As an
experiment, we have generated a series of forecasts for Washington that use the
economic confidence bands of the Los Angeles economy (around the base RFA
Washington forecast). The results are shown in the final column of Table 1. With
this equivalent (and greater) amount of economic risk, the standard deviation in
Washingtons IRR rises to 1.78. Thus, the greater supply problems in Washington
are responsible for about 40 basis points of relative extra risk in comparison to
Los Angeles.
Assuming the IRR distribution is normal, the five observations available can quite closely
approximate the distributions mean and standard deviation.
References
Bodie, Z, A. Kane, and A. Markus, Investments, Irwin (Boston), 1993
Hamilton, John, Modern Times Series Analysis, Wiley and Sons (New York), 1996.
Shiller, R, and K. Case, The efficiency of the market for Single Family Homes ,
AER, 77, 3 (1989) pp111-222.
Wheaton, W. Real Estate Cycles: Some Fundamentals , Real Estate Economics,
22,3 (summer) 1999 (forthcoming).